Andrew Petry is a partner and finance specialist based in Simmons & Simmons’ London office. His practice has a particular emphasis on banking, project finance in the PPP, renewables, waste, power, transport, accommodation and LNG sectors. Andrew’s clients are financiers, project sponsors, borrowers, public sector entities and infrastructure funds.
Simon Kenolty is a managing associate in Simmons & Simmons’ London office who advises lenders, sponsors, financial investors, procuring authorities and contractors on a wide range of projects in Europe, the Middle East and Africa, covering the energy, water, infrastructure, and oil and gas sectors.
Their recent work includes advising the lenders on the €800 million 630MW Markbygden onshore wind farm in Sweden – winner of Europe Wind Deal of the Year at the Thomson Reuters PFI Europe Awards 2017–EKF, the Danish export credit agency, on the £2 billion Walney offshore wind farm extension, the government of Kenya on a US$750 million infrastructure loan, an international consortium on their bid for a BOO greenfield solar PV plant and ancillary transmission facilities in Saudi Arabia, and Mitsubishi Corporation and TEPCO as sponsors on the US$3 billion 2,400MW/130MIGD Facility D independent water and power project
“Mrs May’s Conservative government has continued to look favourably on major rail investment projects, a good example of this is HS2, which is designed to link London more effectively to the north of England.”
GTDT: What have been the trends over the past year or so in terms of deal activity in the project finance sector in your jurisdiction?
Andrew Petry: There seem to be many business decisions being put on hold pending greater clarity emerging on Brexit and its implications. What many businesses have done is to make contingency plans and some have taken action with the hope of making themselves as Brexit-proof as possible. This is true of the energy and infrastructure sectors as much as any other sector. The exchange last June by Mrs May of her position as the head of a government with a small majority for a position as head of a minority government has significantly harmed her ability to exercise control over the Brexit process. She is forced to balance the opposing wings of her party and one of the effects of this balancing act is a decline in business confidence. Time is marching on and so clear contours of the United Kingdom’s future relationship with the European Union will need to emerge soon.
Simon Kenolty: To date, few if any investors have announced an intention to stop investing in energy and infrastructure assets in the United Kingdom although we have noticed a dip in the level of focus on the UK by energy and infrastructure investors as the eurozone starts picking up, leaving UK growth behind. Nevertheless, as far as investment activity in the United Kingdom over the past year or so is concerned, the picture seems to be consistent with recent UK trends in that the country continues to deliver a significant number of energy and infrastructure finance opportunities no matter what the government is doing. The transactions have been initiated more in the private sector than in the public sector and, according to our research, refinancings outnumbered secondary market sales and primary transactions in each market segment by roughly two transactions to one.
AP: There are few large transactions on the public sector side with most of the political attention and debate continuing to focus on the ‘3H’ large trophy projects – Hinckley Point C, Heathrow third runway and High Speed Two (HS2). The parliamentary bill for the first phase of the HS2 received Royal Assent in February 2017. The use of PFI/PPP or, indeed, PF2 has once again become a live political issue following a recent National Audit Office report and Carillion’s collapse. Questions about inappropriate risk transfer to contractors have been raised in the media, the opposition state that they will nationalise all public–private partnership (PPP) transactions and no-one appears to be willing to make the case for private sector involvement in infrastructure development in public.
GTDT: In terms of project finance transactions, which industry sectors have been the most active and what have been the most significant deals to close in your jurisdiction?
SK: In terms of PPP/PFIs, deal flow continues to be limited. The Silvertown Tunnel PPP under the Thames has been delayed for a further air quality assessment. Following this, the Strabag Skanska consortium withdrew from the bidding, leaving only two bidders, which has negative implications for competitive business and value for money. The Lower Thames Crossing tunnel between Essex and Kent will have the approach roads procured as a single PPP but the tunnel itself will be directly procured by government.
AP: In spite of the relentlessly negative government and public attitude to PPPs, a few new PPP transactions did come to market in 2017, including a couple of hospital financings and a handful of schools PPP transactions under the Priority School Building Programme. The Welsh government introduced a new Mutual Investment Model PPP scheme, with three projects (healthcare, road and schools) totalling £1 billion in the pipeline for 2018. The industry will be watching the implementation of the new model with interest although many industry commentators see the PFI/PF2 model as no longer politically sustainable and look to economic infrastructure and hybrid transactions such as Thames Tideway Tunnel as representing the future.
Mrs May’s Conservative government has continued to look favourably on major rail investment projects; a good example of this is HS2, which is designed to link London more effectively to the north of England. This project is scheduled to be developed in at least two phases: a first phase connecting London to Birmingham and a second phase connecting Birmingham to Leeds and Manchester. There does not seem to be consensus on price tag, but costs over £90 billion are being cited (up from £56 billion). Simmons & Simmons advised the government on the core contracts for HS2. Even though HS2 is not yet operational, an HS3 that will connect Leeds with Manchester as part of the Northern Powerhouse programme is already being mooted.
SK: The multibillion-pound Crossrail project (around £15 billion), linking central London on a fast west–east axis with Reading, Heathrow, Essex, Kent and the wider Southeast, is now very well advanced and services are due to commence on the central section by December 2018. Following revision to the programme, this will be followed by a phased introduction of services along the rest of the Crossrail route with full service in December 2019. It remains to be seen whether this timetable will be achieved in the face of increasing cost and schedule pressure. There is talk of a Crossrail 2 project intending to serve stations throughout the South East, linking southwest and northeast London, as well as destinations in Surrey and Hertfordshire. This project is mooted to have a price tag of £32 billion and is already causing political controversy, with calls for northern rail projects to be given preference.
There is also ongoing change in the rail sector being implemented via government-owned Network Rail with redevelopments of stations such as the revamped London Bridge station, investment in digital railway, the renovation of railway arch assets and the sell-off of surplus real estate. There are other rail investments mooted such as the extension tunnelling work already completed in November 2017 for the Northern Line (part of the underground system in London) to the redeveloped Battersea Power Station site. In terms of train operation, the early handback of the East Coast Main Line has caused controversy about the role of private train operators. The government is considering introducing formal joint ventures (JVs) between private train operators and state-owned Network Rail to improve coordination and efficiency.
AP: Outside directly government-procured sectors, the most active sector continues to be renewables, particularly on- and offshore wind. Having said that, according to Bloomberg New Energy Finance investment in renewables during 2017 dropped by 56 per cent year-on-year, which has been linked to the extensive rollback of government support for clean energy projects since the Conservative election victory in 2015.
The government removed many of the subsidies for renewables in 2015 soon after taking office and caused a rethink on a number of projects. The independent Committee on Climate Change recently raised concerns about the lack of a route to market for renewables such as solar and noted that this leaves the government’s carbon reduction goals highly reliant on new nuclear and interconnectors (with interconnectors themselves exposed to post-Brexit trading risks if the United Kingdom leaves the European Union’s Internal Energy Market).
The Swansea Bay tidal lagoon project is still in doubt as central government has so far failed to commit to supporting the project after publication of the Charles Hendry report in February 2017, although central government has said that it is still in talks now that the project has revised its Contracts for Difference (CfD) offer to match Hinckley Point C’s £92.50/MwH for 35 years (it was previously £89.90/MwH for 90 years). The Welsh government, on the other hand, has indicated that it may provide substantial support to kickstart the project.
SK: A notable feature of 2017 was a sharp drop in the cost of offshore wind projects in CfD auctions, with Hornsea 2, Moray and Triton Knoll bidding £57.50–£74.75 per MWh for a total of 3,196MW. This represents a roughly 50 per cent drop on average since the February 2015 CfD auction. This follows the sharp drops elsewhere in Europe and illustrates the growing economies of scale, particularly driven by increasing turbine size. At the same time, other technologies such as solar are being developed on a subsidy-free basis, including with corporate power purchase agreement (PPA) backing.
AP: The UK has also continued its commitment to new nuclear, for which an EDF and Chinese consortium was awarded an above-market tariff of £92.5 per MWh to encourage their developments at Hinckley Point C. However, the sector is being beset by delays notwithstanding the fact that the project continues to receive support. The sector has also been hit by financial difficulties at Westinghouse and Toshiba, developer of Moorside for which Kepco is now preferred bidder, while Hitachi is reported to be seeking Japanese and UK government financial backing for its Wylfa project. Providing direct financial support would be a significant departure from the UK government’s current approach of only providing price support.
Two related sectors that have shown high levels of activity are the secondary sales and refinancing sectors. Trading energy and infrastructure assets to meet the growing demand of institutional investors for what they consider part of their ‘alternative asset’ portfolio is a growing business, as is refinancing existing transactions, often with funds provided by institutional infrastructure debt funds or directly by lending arms established by institutional investors. A notable secondary market infrastructure transaction in 2017 was the £3.3 billion sale of the HS1 rail concession to a consortium including the National Pension Service of Korea, HICL Infrastructure and Equitix.
“Notwithstanding Brexit concerns, the UK remains one of the most open economies to foreign investors and the government is keen to encourage this.”
GTDT: Which project sponsors have been most active in driving activity? Which banks have been most active in providing debt finance?
SK: Notwithstanding Brexit concerns, the UK remains one of the most open economies to foreign investors and the government is keen to encourage this. As a result, the UK continues to attract investors from all around the world. Institutional investors have increasingly been taking part in greenfield and brownfield financings as well as refinancings of operational assets. We have seen numerous transactions where overseas buyers have funded or acquired infrastructure in the UK and expect this to continue in the next 12 months.
AP: On the debt side, the more restricted availability of bank debt coupled with low returns on government bonds and other investments and a concerted push by governments to stimulate institutional infrastructure lending has served to stimulate new money coming into the market from institutional funders and specialist infrastructure debt funds. Some funders are increasingly buying up the debt on operational projects either by deploying their own funds or investing on a managed account basis. Many of these funders are also moving into funding greenfield projects with some institutional funders overcoming in large part the issues of inflexibility that have traditionally put them at a disadvantage when compared with banks. A number of banks such as BNP Paribas and Crédit Agricole from France, Mitsubishi UFJ and SMBC from Japan, Norddeutsche Landesbank and Bayern LB from Germany, Commonwealth Bank of Australia and Santander remain active, while banks such as RBS and Allied Irish Bank are looking to increase their project finance activity again, and banks such as ABN AMRO are returning to the market. Tenors are, however, constrained by Basel III considerations to around the 20-year mark with longer-dated money almost invariably provided by institutional investors even if it is offered by a bank.
GTDT: What are the biggest challenges that your clients face when implementing projects in your jurisdiction?
AP: Currently one of the biggest challenges for our clients is finding investible transactions. The majority of secondary investors wish to buy off-market and sell in competitive auctions, but if everyone seeks to do this the market becomes unsustainable. Some institutional or funds investors need to find very large transactions to make their involvement worthwhile and therefore good opportunities for them can be few and far between. This has been the case for some time now, but debt remains comparably very cheap and there has been record fundraising in the sector which means even greater resources competing for the assets that do come into play – both on the debt and the equity sides.
SK: The unexpectedly strong showing for the Labour party in the 2017 election and its proposals to acquire equity in PPP/PFI vehicles at a price set by Parliament rather than the market should lead to an increased sense of political risk, which we expect to be reflected in increased pricing rather than developers or lenders declining to invest, but it is not clear at present whether this is the case.
Carillion’s liquidation and the difficulties experienced by sponsors or other contractors suggest that for PPP/PFIs one challenge for sponsors and lenders is to decide if the risk allocation and pricing on a project is commercially sustainable once the potential for cost overruns and delay during construction are factored in. It also illustrates the importance of carefully selecting JV partners and ensuring adequate credit support for equity and performance obligations, given the need for JV partners to plug the hole in projects caused by Carillion’s collapse. Galliford Try’s proposed £150 million equity raise is a good example of this.
GTDT: Are there any proposed legal or regulatory changes that may give rise to new opportunities in project development and finance? Do you believe these changes will open the market up to a broader range of participants?
AP: It is safe to say there is a general consensus that infrastructure investment is good for the economy. Mrs May’s Conservative government has recommitted to the grand schemes mentioned earlier as well as the roll-out of high-speed broadband, smart metering and other initiatives. What has not changed is the hostility in government and the opposition Labour party to private finance and PPPs. There is a growing crisis among NHS trusts and the NHS more generally, the education sector and other areas of the state where PPPs have in the past extensively been used to fund infrastructure. The new infrastructure was typically warmly welcomed when it was procured but now, as budgets are either cut or need to stretch further, the procuring entities find that they are not able to raid maintenance budgets or mothball their infrastructure without the cost of their change of mind being financially painful. Various solutions are being developed to alleviate the pressures put on the public entities caught in this situation.
SK: Given the well-publicised difficulties in developing new nuclear, the risk that the UK will have insufficient power generating capacity in the coming years remains a serious one and the question of how to support UK nuclear power remains unanswered. No new nuclear reactor has started generating power since Sizewell B in 1995 and the likelihood that the new nuclear generation capacity will be ready later than hoped for is high. Filling the generation gap is therefore becoming an increasingly critical issue. Solutions may involve extending the life of existing nuclear plant, government buying minority stakes in proposed UK nuclear projects or providing credit guarantees, more international interconnectors and a resurgence in the use of gas-fired plant as the price of LNG and gas comes down.
AP: One of the most important changes in the power sector is the decline in price support for renewables. Another related factor is the move away primarily from diesel, but also petrol, for use in the transport sector. The government appears to be sitting back and allowing the uncertainty over the future of diesel to affect car sales and other investment decisions without actually planning for the consequences of these changes (eg, by stimulating the build-out of a charging points network).
SK: Also on a negative note, one of the implications of Brexit is that the UK will leave the European Union’s Internal Energy Market with possibly consequent restrictions on its ability to trade energy with the EU through interconnectors. Proposals to address this are urgently needed, as noted by the House of Lords’ recent ‘Brexit: energy security’ report.
AP: The European Investment Bank (EIB) has not formally announced it will no longer invest in the UK, but then equally nor does it currently appear to be signing any transactions. What is clear is that the EIB no longer wishes to accept the jurisdiction of the English courts in their documents and will only accept English law as the governing law for their contracts in exceptional circumstances. In this regard we are in a period of uncertainty that will continue at least as long as it will take to negotiate the terms of Brexit and quite probably for some time beyond.
“The biggest threats to infrastructure investment undoubtedly remain political risk and lack of deal pipeline.”
GTDT: What trends have you been seeing in terms of range of project participants? What factors have influenced negotiations on commercial terms and risk-allocation? Are there any particularly innovative features?
SK: Contract terms are looser and we are frequently seeing features such as equity bridge loans, debt service reserve facilities and other financial enhancements that reduce the cost of funding at the expense of a degree of lender comfort and security. Another issue that has been highlighted recently is the fragility of some of the developers’ and the engineering, procurement and construction and facilities management providers’ balance sheets, which can be an inhibiting factor for the sector. This poses risks for JV partners and off-takers as well as lenders, as illustrated by the costs that Carillion’s JV partners (such as Kier and Galliford Try) and customers (such as the government) are having to absorb. This is also impacting infrastructure investment funds such as HICL and JLIF, which are facing blocks on dividends due to financing events of default and costs for bringing in substitute long-term contractors.
AP: The need for funding is one that has become a global issue and the increasing involvement of institutional money on the equity and the debt side is having an impact on how transactions are being structured with fixed interest debt funding and modified make-whole provisions becoming more common. Some of the assets that were bought by closed-ended funds in the mid 2000s have been coming to market as the funds need to realise their investments with other funds seeking to develop strategies to hold on to their assets through extension and continuation fund strategies. What we are not seeing perhaps as much as we had anticipated is reliance on the capital markets for project financings.
SK: The other feature seen increasingly in the renewables market is the use of corporate PPAs to provide long-term price certainty for projects in place of declining government support.
GTDT: What are the major changes in activity levels or new trends you anticipate over the next year or so?
SK: The biggest threats to infrastructure investment undoubtedly remain political risk and lack of deal pipeline. The unprecedented period of historically low interest rates is coming to an end. Although there is a pressing need for new economic infrastructure, there are serious concerns that the overriding demands of delivering Brexit are limiting the ability of government to develop and implement innovative infrastructure solutions.
AP: The fact that oil price has not really recovered and the North Sea is well past its peak production means that investment in the North Sea remains slow and has largely been on hold. Notwithstanding that, the stress that the whole sector has been under has led to significant M&A opportunities, such as the sale by Shell and Ørsted of their respective North Sea oil interests. Faced with falling oil and gas revenues from the North Sea and discoveries of new oil and gas fields having dropped further in 2016 to a 60-year low, the trend continues to be the offloading by oil majors of their assets in the sector. Increasing decommissioning activity may provide opportunities for transactions.
SK: An exciting feature of 2017 has been the rapid developments in battery storage and its integration into the wider energy market. This will continue to accelerate in 2018, although for storage to achieve its full potential its unique characteristics compared to generation need to be properly recognised by electricity market regulation. The UK government has recently started providing initial financial support to development of electric vehicles and to grid projects using electric vehicle batteries for distributed storage.
The Inside Track
What three things should a client consider when choosing counsel for a complex project financing?
Clearly price is always important, but a client needs to look behind the numbers and ensure they are getting the lawyers they need. Often those whom the client meets at the pitch meeting and on whose reputation and presentation the client bases their choice of adviser will be much less evident during the day-to-day advice on a project.
The lawyer a client hires should have a broad experience base to draw upon but also be part of a wider team that is able to support the chosen counsel in the whole range of potentially relevant non-core skills. At the same time a good projects lawyer needs to master a very wide range of skills and, while they should involve specialist colleagues as appropriate, they should never totally abrogate responsibility for the specialist aspects of a piece of advice to colleagues.
A client should think carefully about the kind of lawyer who will complement the client’s team the best. Projects lawyers should be proactive problem-solvers who understand the client’s business, the project and the technology and are not afraid, when needed, to propose solutions that differ from what is orthodox. Some clients prefer their counsel to lead and drive forward a transaction, but very many prefer to have external counsel perform more of a support role to the in-house team. A good lawyer should be able to perform both kinds of roles and fit seamlessly into the wider client team whatever the dynamic that team may have. The importance of personality fit should not be underestimated given the long hours and stressful situations that are inevitable on a project.
What are the most important factors for a client to consider and address to successfully implement a project in your country?
Investors should not underestimate how UK regulatory regimes and the politics of infrastructure investment can unexpectedly evolve and have an impact on deal flow and how transactions are structured. This has been true recently in the renewables space but is true of other sectors too, particularly given the potential stress of implementing Brexit.
What was the most noteworthy deal that you have worked on recently and what features were of key interest?
As far as UK deals are concerned, we are currently advising the UK government on some strategic nuclear decommissioning issues and have continued to advise investors and contractors on a range of renewables transactions, predominantly in the solar and wind sectors. We also advised EKF, the Danish export credit agency, on its first issuance of a guarantee for CPI-linked project debt provided by Macquarie’s MIDIS as part of an approximately £1.3 billion bond financing debt package, to support construction of the approximately £2 billion Walney offshore wind farm extension. Ørsted (formerly known as DONG) simultaneously sold a 50 per cent stake to two Danish pension funds. This was therefore a complex bond financing, novel ECA guarantee and project acquisition wrapped into a single transaction. This transaction won European Renewables Deal of the Year at the Thomson Reuters PFI Europe Awards 2017.
Apart from advising on numerous refinancings and secondary acquisitions in the sector, we are advising on a borrowing-base style revolving renewables fund holdco financing and we are also advising an oil and gas major on its disposal of site service facilities on one of its industrial sites in the UK, which involves not only the auctioning off of a complicated asset but also endowing it with an untested service contract, which will be required to deliver its ongoing businesses at the site with uninterrupted services.
Andrew Petry and Simon Kenolty
Simmons & Simmons LLP